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Tuesday, May 13, 2008

The Folly of Stop-Loss Orders

A stop-loss order is an order with a broker to sell stock at a certain price. If you own 100 shares of ABC stock that is trading at $10 per share, you might place a stop-loss order to sell if it goes down to $9 per share. This limits how much you can lose on the stock.

If the stock never goes down to $9, then the stop-loss order is never triggered. But, if something happens that causes ABC stock to fall very quickly, your stop-loss order may get triggered at a price below $9. But, most of the time the sale occurs at roughly the price level you pick.

On the surface, this seems like a good idea. You are limiting your losses to 10%, and there is unlimited upside. Would a competent stock picker use stop-loss orders? I’ll show that the answer is no.

A competent stock-picker is someone who is able to evaluate companies and identify one or more businesses whose future prospects indicate the stock is underpriced. Suppose that Carl is a competent stock picker and he has identified ABC Company as a business whose stock is underpriced at $10. He expects a significant stock price increase over the next 3-5 years.

If ABC stock drops to $9, Carl wouldn’t be concerned because he believes that the business is doing well and that the market just hasn’t caught on yet. Rather than selling his stock, Carl is more likely to buy more at the lower price.

Stop-loss orders simply make no sense for Carl. He buys and sells based on the attributes of the business relative to its current price. Why would he sell at a price that he judges to be too low? Carl is more likely to sell if ABC stock runs up to $30 without any real justification.

Does this mean that you should always buy more when your stock goes down? Absolutely not. Sometimes a stock drops because of very bad news. Carl may choose to sell ABC after a price drop if he thinks the news seriously affects ABC Company’s long-term prospects as a business.

Few people fall into the category of competent stock pickers. If you still like the idea of stop-loss orders, then this is a good sign that you’re not in this category.

3 comments:

Excellent points. A stop-loss order is basically a "perceived" insurance against mounting loses over (say) 10%, but that only works if the investor withdraws from the market forever. A stop-loss order won't prevent his next investment from losing another 10%.

I think (correct me if I'm wrong) that a stop loss order, when triggered, causes a market sell order to be immediately issued. Some people say that market orders should never be used, they are for suckers only, especially for an illiquid stock (most of them have a huge pile of bids at the 0.01 level, to soak up market sell orders by people that don't know any better). Other people say that stop loss orders have their place, especially in the case when you are on holidays and unavailable to deal with your portfolio.

In general, never use a stop-loss order, but instead use a stop-limit order if you really need to backstop yourself when away.

Jim: There is a difference between stop-loss and stop-limit orders as you describe. But if you feel the need to use either one, then you aren't investing properly. It makes no sense to sell an investment because it became cheaper. If you know the value of the company, then you should be interested in buying more when the price drops. Stop-loss and stop-limit orders are mainly for people who buy stock for momentum reasons. Almost all such investors get worse results over the long run than if they had just bought a low-cost broad index ETF.